Markets can Trump Voters

Voters in some eurozone countries have rebuffed politicians wanting to impose stringent austerity measures on them. Some commentators have construed this to mean that governments in the eurozone should now spend their way out of the current recession. They are wrong. Governments need to access markets for funds. And the markets today have a stronger veto on governments than voters. If newly-elected eurozone governments choose to defy the markets, the global economy will face a first-rate crisis.

The signs of voter discontent are everywhere. In Greece , pro-austerity mainstream parties got only 30% of the popular vote. In France, President Sarkozy lost to Hollande , who has promised to roll back some of the austerity measures Sarkozy had agreed to under the fiscal compact that eurozone countries had signed in March. Earlier, the Dutch prime minister had to resign when a right-wing group withdrew support for budget cuts he had proposed. Eurozone voters clearly do not like the austerity rammed down their throats. It’s not hard to understand why.

The IMF expects the eurozone as a whole to shrink by 0.3% this year. GDP in Greece is expected to decline by nearly 5% this year on top of a 7% decline in 2011. Italy and Spain face GDP declines of 2%. The unemployment rate in the eurozone is 10.9%, the highest since 1997, two years before the euro was launched. It is 22% in Greece and 24% in Spain. Under a bailout package agreed with the IMF, Greece has to raise revenues and sharply cut expenditure, including that on pensions and wages. The fiscal compact signed by all eurozone economies (except UK and Czechoslovakia) requires all governments to abide by strict fiscal targets. These measures are just not working.

Many economists reckon that at current interest rates and assuming reasonable growth rates, no amount of austerity is going to help. Whatever savings are effected in expenditure will be more than offset by the fall in tax revenues that results from a decline in the growth rate. Politicians have responded by promising their voters less austerity and more growth. This is, however, easier said than done. If France chooses to defy the fiscal compact, it would mean a rupture with Germany, with whom it has worked closely in forging the EU. Moreover, any sign of fiscal slippage will be punished by the markets with a sharp increase in yields on government bonds. In a globalised world, markets can trump voters . The bet is that Hollande will settle for a minor compromise with Germany.

However, for Greece and other countries in the periphery, there has to be a solution other than austerity, more spending and deferring the moment of reckoning. Any sensible person knows what that is: writing off some of the debt of these economies. This solution was eventually accepted in the case of Greece and it must now apply to the others. The eurozone already has two funds to which a total of $700 billion has been committed. The funds will have to come either from the stronger economies or from a eurozone bond that is guaranteed by the stronger economies. In either case, a transfer of resources from the stronger economies, which is implied in a fiscal union, is a must.

The IMF has committed $430 billion towards a rescue fund for the eurozone. It is in everybody’s interest to stave off the eurozone collapse, so this amount should be topped up as required. The rescue funds should be used to recapitalise eurozone banks, which is where the trouble originated. Once debt levels are brought down and banks are recapitalised , we will have the conditions in place for growth as well as for meeting tough fiscal targets. The eurozone will then be able to move towards the fiscal union that must complement the monetary union that has taken place.

The world economy will be better placed to shrug off the financial crisis five years after it began. Can we expect to see this happen? France is unlikely to be an obstacle to such a virtuous spiral. The real issue is whether the German chancellor can muster domestic support for a rescue in time to avert a disorderly exit of Greece and a collapse in Spain and Italy. Greece itself will need further debt relief; private creditors find this too much to stomach. The probability of a fresh crisis has gone up.

In India, commentators have pilloried the government for not taking tough measures to restore macroeconomic stability. They want the government to go all out to prune subsidies. Events in Europe may cause them to take a more benign view: democratic governments everywhere face limitations in imposing tough measures.

Economists and rating agencies want the government to compress spending so that private investment is stimulated . Given the uncertainties in financial markets at the moment, however, it may not be a disaster if the fiscal deficit for this year ends up higher than the target of 5.1%. For India, going slow on austerity at the moment may be good economics, not just good politics.